I am a senior editor at Forbes, covering legal affairs, corporate finance, macroeconomics and the occasional sailing story. I was the Southwest Bureau manager for Forbes in Houston from 1999 to 2003, when I returned home to Connecticut for a Knight fellowship at Yale Law School. Before that I worked for Bloomberg Business News in Houston and the late, great Dallas Times Herald and Houston Post. While I am a Chartered Financial Analyst and have a year of law school under my belt, most of what I know about financial journalism, I learned in Texas.

Apple Learns The Hazards Of Innovation With E-Book Antitrust Ruling

A federal judge today held that AppleApple violated antitrust laws by orchestrating a scheme with publishers to raise electronic-book prices, meaning the tech innovator may face a trial for damages over the alleged scheme.

The decision by U.S. District Judge Denise Cote was a victory for the Justice Dept., which sued Apple along with publishers HarperCollins, Hachette, Macmillan, Penguin Group and Simon & Shuster last year, The government said Apple’s actions drove prices up 18% by inducing rival Amazon.com to abandon its $9.99 pricing for best-selling e-books. But it’s a puzzling result given that Apple’s contracts set price ceilings, not floors, and were based partly on Apple’s wildly popular and simplified iTunes scheme.

Apple is being penalized for introducing a new way of selling the printed word online, by providing the electronic marketplace for publishers and taking a fee for every unit sold. That upset the old wholesaling approach, in which marketers bought works at a discount and sold them for what the market would bear. Whether it is illegal will surely be tested in higher courts.

“When firms come up with new pricing schemes that force other companies to adopt new schemes, that’s a good thing,” said George Priest, an antitrust professor at Yale Law School has written critically on the failure of antitrust law to keep up with technological innovation. “This will be appealed, I assure you. And I am not certain it will stand.”

The publishers settled with the government, amid strong evidence they had engaged in discussions on how to substitute Amazon.comAmazon.com‘s “wretched” $9.99 price for e-books for something more lucrative. According to Judge Cote’s ruling, Jobs held off on introducing an Apple book store until the launch of the iPad, which he considered the first suitable electronic reader, and then pushed hard for a pricing scheme that would be simple and profitable for Apple and the publishers.

Judges have long had trouble making old concepts of antitrust law fit rapidly evolving technology. MicrosoftMicrosoft, for example, faced a barrage of antitrust litigation after it drove Netscape out of the browser business by offering Internet Explorer for free. What looked like an anticompetitive assault on Netscape to some was, for others, no different than car manufacturers bundling an FM radio with each new model instead of requiring owners to buy their radios on the aftermarket. The concept of illegal “tying,” or forcing consumers to buy one product in order to get another, is difficult to square with the digital-era practice of constantly adding features to products as their marginal cost drops to zero.

The conspiracy theory against Apple was odd, too, given that it required the judge to conclude that Apple, as a new entrant into the e-book business, had the power to end incumbent Amazon.com’s $9.99 pricing. Key to the conspiracy was Apple’s shift from a wholesale model to an “agency” model under which publishers set their prices and Apple collected a 30% cut.

That alone wouldn’t necessarily violate antitrust laws, but Cote said Apple became central to the conspiracy when it also negotiated “most favored nation” clauses with the five publishers allowing it to drop prices to match the lowest e-book prices on the Web. The judge said those MFN clauses encouraged the publishers to collude and pressure Amazon to adopt a similar scheme.

The clauses “literally stiffened the spines of the Publisher Defendants to ensure that they would demand new terms from Amazon,” the judge said.

Apple argued it negotiated individually with the publishers and didn’t know they were engaging in illegal talks behind the scenes (according to the decision, executives met over dinners in New York, without corporate lawyers, to discuss how to deal with Amazon’s aggressive pricing.) It also presented evidence that prices actually fell over the two-year period after it introduced the iPad and the new e-book pricing scheme in early 2010. The judge disregarded that evidence, saying it failed to control for other changes in the electronic-book marketplace.

There was plenty of damaging evidence in the case, including statements Jobs made to a reporter after the launch of the online book business. The reporter asked how Apple would compete with e-books priced at $12.99 when they were available on Amazon for $9.99. “The price will be the same,” Jobs said, because publishers would soon begin withholding their works from Amazon.

I’m reminded, however, of an epic antitrust trial in Galveston, Tex. that I covered in the early 1990s in which several airlines sued American Airlines over its short-lived simplified pricing scheme. That case featured some of the most talented trial lawyers on the planet, including Joe Jamail,David Boies, and Finis Cowan, and lots of juicy evidence. (The judge refused to allow in the best evidence of all, a taped phone conversation between former AMR Chairman Bob Crandall and his counterpart at Braniff Airlines, in which Crandall offered to raise fares out of Dallas if Braniff did the same.)

The other airlines argued American tried to drive them out of business by substituting the convoluted pricing that emerged in the wake of airline deregulation with a simplified fare schedule which, they argued, set prices below cost. American said it was trying to make things easier on consumers by setting fares in simple bands.

The main problem with the case was one that academics like Priest have pointed out for years: so-called “predatory pricing” is unlikely to succeed because a company trying to drive competitors out of the market by pricing below cost will bankrupt itself in the process. What looks predatory to a disgruntled competitor might simply be an innovation designed to drive more purchases by consumers. American failed with its pricing scheme, but Southwest Airlines became the most profitable carrier in the business by lowering prices and stimulating demand.

Priest said there have been other examples of technology and innovative pricing combining to produce big antitrust cases. IBM battled the government for years over its mainframe computer business, for example. Big Blue could charge customers more for its mainframes because they provided greater value, Priest said, not because it controlled the market for computing.

“There are lots of other occasions where the price has gone up as a result of new technology and it’s a natural feature of competition,” Priest said. “The lowest price isn’t always the right price.”

Apple played hardball with the publishers when it wanted to open its online bookstore, and as with online music, Steve Jobs got his way. One argument could be that by allowing publishers to set prices at levels they think can sustain the business, readers are assured a steady supply of works by talented authors. There’s always competition, after all: Authors can sell their books directly through Amazon and other online markets and cut out publishers and agents entirely.

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It has become acceptable for anti-competitive and anti-consumer practices by this corporation to be spun in positive terms as “innovation”. I suppose when criminals such as murderers and thieves hatch their plots, these are sometimes innovative — but we would tend not to use such flattering terminology.

What’s next ? “War is peace.” (1984)

This is the latest in a series of articles on this website this week spinning Apple’s failures as success.

No body forced any one to buy anything. You claim capitalists are totalitarian? At least they are still against communism. The American left is admittedly socialist, & radically communist & maoist as well.

The right is THEOCRATIC! I want you to learn that word, o.k.. That is why the right is completely wasted in America. They have their heads up their priests a… …have a nice freaking day. : )~

I am no fan of Apple, particularly its wretched and incomprehensible Synch feature. But it’s hard to see how negotiating price ceilings with publishers became a scheme to raise prices across a fiercely competitive market.

Is it really that difficult to comprehend that this sets a minimum price for all the other retail outlets?

The combination of agency and MFN is toxic. If a competitor to Apple could work successfully on 10% margin rather than 30%, it does the consumer no good, because the publisher is not going to let Apple’s competitor drop prices for the simple reason that then the publisher would receive less money from Apple, because it has to let Apple match the competitor’s price.

So the publisher has zero incentive to allow an upstart to try to compete on price. Since that’s often all an upstart is able to compete on (since it’s brand new, it will have zero reputation), this severely stifles competition.

Note that in a truly free market, one would expect that _some_ publisher would buck the trend to compete, but Apple is big enough that any upstart publisher would have to deal with them, and then we are back to square one.

You lost me. How does a publisher prevent an Apple competitor from dropping its price? And what is the role of Amazon, which has an overwhelming share of the e-book market? I am failing to see how Apple can monopolize this business.

As stated in the department’s complaint, one publisher’s CEO said, “Our goal is to force Amazon to return to acceptable sales prices through the establishment of agency contracts in the USA. . . . To succeed our colleagues must know that we entered the fray and follow us.”

As far as the publishers are concerned, Amazon was toxic because it was devaluing the prices of books. If you sell a book as a loss leader, you might damage future demand for the book at a higher price point.

The publishers saw Apple as a potential foil to this, which is why they were willing to sign on. From the publisher’s perspective, if a customer has to go to Apple instead of Amazon to buy the book it’s not a huge problem, because most rich customers have iWhatevers in any case.

This is a very odd article… I’m not convinced at all that Apple working with publishers in a coordinated attempt to fix prices higher in order to get bigger margins is “innovation.” Isn’t the point that prices were $9.99 through Amazon and that was deemed too cheap? $9.99 for a book seems pretty simple to me.